8/17/2007 @ 5:20PM

Disinherited by Vanguard

Is it time to move your IRA?

In late July the Vanguard group sent 170,000 customers a form letter innocuously labeled: “Change in beneficiary policy will help you simplify your planning.” A more candid heading would have been: “Warning! Unless you act, we’re about to change who gets your Individual Retirement Accounts when you die.”

Vanguard has decided that, as of mid-September, it will require customers to use identical beneficiaries for all IRAs of the same type. All your IRAs holding money rolled from employer pension plans count as the same type and must have the same beneficiaries. Traditional IRAs, both pretax and aftertax, are a second type. Roth IRAs are a third.

If you’re one of 170,000 customers who now have different beneficiaries named for separate IRAs of the same type or different beneficiaries for different mutual funds within a single IRA, Vanguard will apply the newest beneficiary form to all your IRAs of one type–unless you contact Vanguard and direct otherwise. If two forms were submitted at the same time, Vanguard will treat the one it processed later as newer. This is crucial, since it’s the form–not your will–that determines who gets your IRAs.

Say you’ve named your older child primary beneficiary of one rollover IRA and your younger child primary beneficiary of another. If you don’t read your mail carefully, or were on vacation or in the hospital when the letter came, and you die without contacting Vanguard, one of your kids could be done out of his IRA inheritance. When FORBES showed Vanguard’s letter to IRA experts, they were outraged. “This borders on the unconscionable,” fumed Green Bay, Wis. CPA Robert Keebler. “It’s crazy. I don’t see how they can change the beneficiaries on your accounts without your consent,” said Boston lawyer Natalie Choate.

Colin Kelton, the Vanguard official who signed the July letter, argues customers are getting adequate advance notice and will get a second letter in September alerting them that the beneficiary change has been made.

What if clients pick up the phone and ask to keep different beneficiaries for separate IRAs of the same type? In two customer service calls FORBES was told that’s impossible. “There’s no way to override the computer,” declared one rep. He added that Vanguard is “a low-cost provider” and permitting different beneficiaries would increase its costs.

The other rep insisted that Vanguard’s competitors wouldn’t allow it either. Not so. Fidelity and
Charles Schwab
, which hold the most IRA assets, said clients can name different heirs for different accounts of the same type. So did American Funds, Citibank, E-Trade,
Janus
,
Merrill Lynch
, MFS and
Wachovia
. Of those we surveyed, only T. Rowe Price doesn’t allow it.

Kelton said that Vanguard might make an exception if a customer could show different beneficiaries were needed. But he couldn’t think of any examples where they would be, and those we offered–all cases where lawyers advise it–didn’t qualify, he said. What if you want to leave one IRA to charity and one to your kids or one to your kids from your first marriage and one to your current spouse? Kelton says a customer should indicate on the form the percentage each heir is to get and the executor of his estate can split the IRA up.

The Internal Revenue Service has allowed such postmortem IRA splits since 2002. But the executor must meet strict deadlines. If, for example, an IRA going partly to charity isn’t split in time, other heirs lose the ability to stretch out payouts and tax deferral over their own lives. So many advisers recommend establishing separate IRAs for separate beneficiaries before your death. “That way, it can’t get goofed up,” says Keebler. Stephanie Rapkin, a Mequon, Wis. estate lawyer, was leaving one Vanguard IRA to charity and another to her family. Now she plans to move them both from Vanguard.

What if you want to invest IRA funds for different beneficiaries differently, based on their own assets or taste for risk? Will Vanguard allow different beneficiary forms in that case? No, says Kelton, because it could drag Vanguard into family disputes, and curbing litigation is one reason it’s changing its policy. The real problem is that Vanguard has allowed an account owner to name one beneficiary for one mutual fund and a different beneficiary for another fund within a single IRA. Later, the beneficiary of a dud fund might argue that when the IRA was set up, his fund had 50% of the money and that the account owner really meant to leave him 50% of the whole account. But that’s not a problem with separate beneficiaries for separate accounts.

Estate lawyer Choate speculates that Vanguard could end up getting sued anyway–by beneficiaries who were accidentally bumped.